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Chapter 11 - Equity Analysis And Valuation

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Equity Analysis and Valuation

REVIEW Equity analysis and valuation is the focus of this chapter. This chapter extends earlier analyses to consider earnings persistence and earning power. Earnings persistence is broadly defined and includes the stability, predictability, variability, and trend in earnings. We also consider earnings management as a determinant of persistence. Earning power refers to the ability of the core operations of a company to operate profitably. Our valuation analysis emphasizes earnings and other accounting measures for computing company value. Earnings forecasting considers earning power, estimation techniques, and monitoring mechanisms for analysis. This chapter describes several useful tools for equity analysis and valuation. We describe recasting and adjustment of financial statements. We also distinguish between recurring and nonrecurring, operating and nonoperating, and extraordinary and nonextraordinary earnings components. Throughout the chapter we emphasize the application of earnings-based analysis with several illustrations.


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OUTLINE

• Earnings Persistence Recasting and Adjusting Earnings Determinants of Earnings Persistence Persistent and Transitory Items in Earnings

• Earnings-Based Equity Valuation Relation between Stock Prices and Accounting Data Fundamental Valuation Multiples Illustration of Earnings-Based Valuation

• Earning Power and Forecasting for Valuation Earning Power Earnings Forecasting Interim Reports for Monitoring and Revising Earnings Estimates


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ANALYSIS OBJECTIVES • Analyze earnings persistence, its determinants and its relevance for earnings

forecasting. • Explain recasting and adjusting of earnings and earnings components for analysis. • Describe earnings-based equity valuation and its relevance for financial analysis. • Analyze earning power and its usefulness for forecasting and valuation. • Explain earnings forecasting, its mechanics and its effectiveness in assessing

company performance. • Analyze interim reports and consider their value in monitoring and revising

earnings estimates.


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QUESTIONS 1. The significance and potential value of research and development costs are among the

most important for financial statement analysis and interpretation. They are important not only because of their relative amount but also because of their significance for the projection of future performance. The analyst must pay careful attention to research and development costs and to the absence of such costs. In many companies they represent substantial costs, much of them of a fixed nature. We must make a careful distinction between what can be quantified in this area, and consequently analyzed, and what cannot be quantified and must consequently be evaluated in qualitative terms. While a quantitative measure of the amount of R&D expenses is not difficult, it is often difficult to evaluate the quality of research and development costs and their effect on future earnings. There seems to be no clear-cut definition of "research." Therefore, it may not be meaningful to compare the quality of the research and development costs of two companies. Still, the analyst should evaluate such qualitative factors as the caliber of the research staff and organization, the eminence of its leadership, as well as the commercial results of their efforts. One would also want to consider whether the research and development is government-sponsored or company-sponsored.

2. The reported values of most assets in the balance sheet ultimately enter the cost

streams of the income statement. Therefore, whenever assets are overstated, then income is overstated because it has been relieved of charges needed to bring such assets down to realizable value. The converse should also hold true, that is, to the extent to which assets are understated, the income, current and cumulative, is also understated. Turning to the relation between liabilities and income, an overstatement of income can occur because income is relieved of charges required to bring the provision or the liabilities to their proper amounts. Conversely, an overprovision of present and future liabilities or losses results in the understatement of income or in the overstatement of losses.

3. The objective of recasting the income statement is so that the stable, normal, and

continuing elements in the income statement can be separated and distinguished from random, erratic, unusual, or nonrecurring elements. Both sets of elements require separate analytical treatment and consideration. Moreover, recasting also aims at identifying those elements included in the income statement that should more properly be included in the operating results of one or more prior periods.

4. The analyst will find data needed for analysis of the results of operations and for their

recasting and adjustment in: • The income statement and components such as:

-Income from continuing operations -Income from discontinued operations -Extraordinary gains and losses -Cumulative effect of changes in accounting principles.

• The other financial statements and the footnotes thereto. • Textual disclosures found throughout the published report, including MD&A. • The analyst may also find unusual items segregated within the income statement

(generally on a pre-tax basis) but their disclosure is optional.


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• The analyst will consult all the above-mentioned sources as well as, if possible, management in order to obtain the needed facts. These will include facts which affect the comparability and the interpretation of income statements, such as product-mix changes, production innovations, strikes, and raw material shortages which may or may not be included in management's mandatory discussion and analysis of the results of operations.

5. Once the analyst has secured as much information as is possible, several years’ income

statements (generally at least five) are recast and adjusted in such a way as to facilitate their analysis, to evaluate the trend of earnings, and to aid in determining the average earning power of the company. While this procedure can be accomplished in one phase, it is simpler and clearer to subdivide it into two distinct steps: (1) recasting and (2) adjusting. The recasting process aims at rearranging the items within the income statement in such a way as to provide the most meaningful detail and the most relevant format needed by the analyst. At this stage the individual items in the income statement may be rearranged, subdivided, or tax effected, but the total must reconcile to the net income of each period as reported. The adjusting process of items within a period will help in the evaluation of the earnings level. For example, discretionary and other noteworthy expenses should be segregated. The same applies to items such as equity in income or loss of unconsolidated subsidiaries or associated companies, which are usually shown net of tax. Items shown in the pre-tax category must be removed together with their tax effect if they are to be shown below normal "income from continuing operations." Expanded tax disclosure enables the analyst to segregate factors that reduce taxes as well as those that increase them, enabling an analysis of the degree to which these factors are of a recurring nature. All material permanent differences and credits, such as the investment tax credit, should be included. The analytical procedure involves computing taxes at the statutory rate (currently 35 percent) and deducting tax benefits such as investment tax credits, capital gains rates or tax-free income, and adding factors such as additional foreign taxes, non tax-deductible expenses and state and local taxes (net of federal tax benefit). Immaterial items can be considered in one lump sum labeled as "other." Analytically recast income statements will contain as much detail as is needed for analysis and are supplemented by explanatory footnotes.

6. Based on data developed in the recast income statements as well as on other available

information, certain items of income or loss are assigned to the period to which they most properly belong. This is a major part of the adjustment process. The reassignment of extraordinary items or unusual items (net of tax) to other years must be done with care. For example, the income tax benefit of the carryforward of operating losses should generally be moved to the year in which the loss occurred. The costs or benefits from the settlement of a lawsuit may relate to one or more preceding years. The gain or loss on disposal of discontinued operations will usually relate to the results of operations over a number of years. If possible, all years under analysis should be placed on a comparable basis when a change in accounting principle or accounting estimate occurs. If, as is usually the case, the new accounting principle is the desirable one, prior years should, if possible, be restated to the new method, or a notation made regarding a lack of comparability in certain respects. This procedure will result in a redistribution of the "cumulative effect of change in accounting principle" to affected prior years. Changes in estimates can be accounted for only prospectively and generally accepted accounting principles prohibit prior year restatements except in certain specified cases. The analyst's ability to place all years on a comparable basis will depend on availability of


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information. Before the trend in earnings can be evaluated it is necessary to obtain the best approximation possible of the earnings level of each year. All items in the income statement must be considered and none can be excluded or "dropped by the wayside." For example, if it is decided that an item in the income statement does not properly belong in the year in which it appears it may be either: (i) Shifted (net of tax) to the result of one or a number of other years, or (ii) If it cannot be identified with another specific year or years, it must be included in the average earnings of the period under analysis.

7. Analysts must be alert to accounting distortions designed to affect trends. Some of the

most common and most pervasive practices in accounting are designed to affect the presentation of earnings trends. These procedures are based on the assumptions that (i) the trend of income is more important than its absolute size, (ii) retroactive revisions of income already reported in prior periods have little, if any, market effect on security prices, and (iii) once a company has incurred a loss, the size of the loss is not as significant as the fact that the loss has been incurred. These assumptions and the propensities of some managers to use accounting as a means of improving the appearance of the earnings trend has led to techniques which can be broadly described as "earnings management." The earnings management process, so as to distinguish it from outright fraudulent reporting, must meet a number of requirements. This process is a rather sophisticated device. It does not rely on outright or patent falsehoods and distortions, but rather uses the leeway existing in accounting principles and their interpretation to achieve its ends. It is usually a matter of form rather than one of substance. Consequently, it does not involve a real transaction (such as postponing an actual sale to another accounting period in order to shift revenue) but only a redistribution of credits or charges among periods. The general objective is to moderate income variability over the years by shifting income from good years to bad years, by shifting future income to the present (in most cases presently reported earnings are more valuable than those reported at some future date) or vice versa.

8. Earnings management can take many forms. Here are some forms to which the analyst

should be particularly alert: • Changing accounting methods or assumptions with the objective of improving or

modifying reported results. For example, to offset the effect on earnings of slumping sales and of other difficulties, Chrysler Corp. revised upwards the assumed rate of return on its pension portfolio, thus increasing income significantly. Similarly, Union Carbide improved results by switching to a number of more liberal accounting alternatives.

• Misstatements, by various methods, of inventories as a means of redistributing income among the years.

• The offsetting of extraordinary credits by identical or nearly identical extraordinary charges as a means of removing an unusual or sudden injection of income that may interfere with the display of a growing earnings trend.

9. There are powerful incentives that motivate companies and their managers to engage in

income smoothing. Companies in financial difficulties may be motivated to engage in such practices for what they see and justify as their battle for survival. Successful companies will go to great lengths to uphold a hard-earned and well-rewarded image of earnings growths by smoothing those earnings artificially. Moreover, compensation plans or other incentives based on earnings will motivate managers to accelerate the recognition of income by anticipating revenues or deferring expenses. Analysts must


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appreciate the great variety of incentives and objectives that lead managers and, at times, second-tier management without the knowledge of top management, to engage in practices ranging from smoothing to the outright falsification of income. It has been suggested that smoothing is justified if it can help a company report earnings closer to its true "earning power" level. Such is not the function of financial reporting. As we have repeatedly argued, the analyst will be best served by a full disclosure of periodic results and the components that comprise these. It is up to the analyst to average, smooth, or otherwise adjust reported earnings in accordance with specific analytical purposes. The accounting profession has earnestly tried to promulgate rules that discourage practices such as the smoothing of earnings. However, given the powerful propensities of companies and of their owners and managers to engage in such practices, analysts must realize that, where there is a will to smooth or even distort earnings, ways to do so are available and will be found. Consequently, particularly in the case of companies where incentives to smooth are more likely to be present, analysts should analyze and scrutinize accounting practices to satisfy themselves regarding the integrity of the income-reporting process.

10. Managers are almost always concerned with the amount of net results of the company as

well as with the manner in which these periodic results are reported. This concern is reinforced by a widespread belief that most investors accept the reported net income figures, as well as the modifying explanations that accompany them, as true indices of performance. Extraordinary gains and losses often become the means by which managers attempt to modify the reported operating results and the means by which they try to explain these results. Quite often these explanations are subjective and are slanted in a way designed to achieve the impact and impression desired by management.

11. The basic objectives in the identification and evaluation of extraordinary items by the

analyst are: • To determine whether a particular item is to be considered "extraordinary" for

purposes of analysis; that is, whether it is so unusual and nonrecurring in nature that it requires special adjustment in the evaluation of current earnings levels and of future earnings possibilities.

• To decide what form the adjustment, for items that are considered as "extraordinary" in nature, should take.

12. Nonrecurring Operating Gains or Losses. By "operating" we usually identify items

connected with the normal and usual operations of the business. The concept of normal operations is more widely used than understood and is far from clear and well defined. Nonrecurring operating gains or losses are, then, gains or losses connected with or related to operations that recur infrequently and/or unpredictably. Examples include: (1) foreign operations giving rise to exchange adjustments because of currency fluctuations or devaluations, and (2) an unusually severe decline in market prices requires a large write-down of inventory from cost to market. The analyst in considering how to treat nonrecurring operating gains and losses would do best to recognize the fact of inherent abnormality in business and treat them as belonging to the results of the period in which they are reported.


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Recurring Non-operating Gains or Losses. This category includes items of a non-operating nature that recur with some frequency. Examples include recurring exchange adjustments, gains and losses on sales of fixed assets, interest income, and the rental received from employees who rent company-owned houses. While items in this category are often classified as "unusual" in published financial statements, the narrow definition of "non-operating" which they involve as well as their recurrent nature are good reasons why the analyst should not exclude them from current results. Nonrecurring, Non-operating Gains or Losses. Of the three categories, this one possesses the greatest degree of "abnormality." Not only are the events here not repetitive and unpredictable, but they do not fall within the sphere of normal operations. In many cases these events are not unintended or unplanned. However, they can rarely be said to be totally unexpected. Business is ever subject to the risk of sudden adverse events and to random shocks, be they natural or man-made. In the same manner, business transactions are also subject to unexpected windfalls. Examples in this category include substantial uninsured casualty losses unrelated to normal or expectable operating risks. It can be seen readily that while the above occurrences are, in most cases, of a nonrecurring nature, their relation to the operations of a business varies. All are occurrences in the regular course of business. Even the assets destroyed by acts of nature were acquired for operating purposes and thus were subject to all possible risks. Of the three categories, this one comes closest to meeting the criterion of being "extraordinary." Nevertheless, truly unique events are very rare. What looks at the time as unique may, in the light of experience, turn out to be the symptom of a new set of circumstances. The analyst must bear in mind such possibilities but, barring evidence to the contrary, he/she can regard items in this category as extraordinary in nature and thus omit them from the results of operations of a single year. They are, nevertheless, part of the longer term record of results of the company. Thus, they enter the computation of average earnings, and the propensity of the company to incur such gains or losses must be considered in the projection of future average earnings.

13. a. Whenever there is a gain (whether it is recorded as extraordinary or not), there is an increase in resources. Similarly, a loss results in a reduction of resources. In this sense, an extraordinary gain or loss is not different from a normal or ordinary gain or loss. Once an asset is written off as a result of extraordinary loss, that asset will not be available in the future to generate revenues. Conversely, an extraordinary gain will result in an addition of resources on which a future return can be expected. Therefore, the financial analyst should measure the potential effect of the extraordinary events on future earnings and evaluate the likelihood of the occurrence of events causing extraordinary items.

b. One implication frequently associated with the reporting of extraordinary gains and

losses is that they have not resulted from a "normal" or "planned" activity of management and that, consequently, they should not be used in the evaluation of management performance. The analyst should seriously question such a conclusion. What is "normal" activity in relation to management's deliberate actions? Whether we talk about the purchase or sale of securities, assets not used in operations, or divisions and subsidiaries that definitely relate to operations, we talk about actions deliberately taken by management with specific purposes in mind. Such actions require, if anything, more consideration or deliberation than ordinary everyday operating decisions because they are usually special in nature and involve


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substantial amounts of money. The results of such activities always qualify or enhance the results of "normal" operations, thus yielding the final net results.

14. Most analysts probably would (should) disagree with this assertion. Management is entrusted with the control of all assets of an entity in every possible way, including extraordinary events. Their responsibility is not confined to "normal" operations, and we can generally assume that every action taken by the management has some specific purpose in mind, be it "normal operations" or "abnormal operations," to enhance company results. It is extremely rare to see a business event that can be termed completely unexpected or unforeseeable. When it comes to the assessment of results that really count and those that build or destroy value, the distinction of what is normal and what is not fades.

15. From a strictly mathematical point of view, the accounting-based equity valuation model

is impervious to accounting manipulations under the clean surplus relation. Firms that overstate net income will have higher book values, which will reduce future residual income. Firms with conservatively measured net income will report lower book values, which will increase future residual income. On the other hand, projections of future profitability are based on current and past financial results. To the extent that accounting manipulations can affect net income forecasts by users, these manipulations will affect firm valuation.

16. a. The major determinants of the PB ratio are (1) future ROCE, (2) growth in book value,

and (3) risk. The major determinants of the PE ratio are (1) the level of current earnings, (2) trend in future residual income, and (3) risk.

b. As illustrated in a chart in the chapter, the joint values of the PB and PE ratios give important insights into the market's expectations regarding earnings growth and future ROCE. To the extent that the analyst can "outguess" the market, s/he will be able to identify mispriced securities.

17. Forecasting must be differentiated from extrapolation. The latter is based on an

assumption of the continuation of an existing trend and involves a mechanical extension of the trend into the uncharted territory of the future. Forecasting, on the other hand, is based on a careful analysis of as many individual components of income and expense as is possible and a considered estimate of future level taking into consideration interrelations among the components as well as probable future conditions. Thus, forecasting requires as much detail as is possible to obtain.

18. The MD&A often contains a wealth of information on management's views and attitudes

as well as on factors that can influence company operating performance and financial condition. Consequently, the analyst will likely find much information in these analyses to aid in the forecasting process. Moreover, while not requiring it, the SEC encourages the inclusion in these discussions of forward-looking information.

19. The best possible estimate of the average earnings of a company, which can be expected

to be sustained and to repeat with some degree of regularity over a span of future years, is referred to as its earning power. Except in specialized cases, earning power is universally recognized as the single most important factor in the valuation of a company. Most valuation approaches entail in one form or another the capitalization of earning power by a factor or multiplier which takes into account the cost of capital as well as


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future expected risks and rewards. The importance of earning power in such that most analyses of income and related financial statements have as one of their ultimate objectives the determination of earnings. Earning power is a concept of financial analysis, not of accounting. It focuses on stable and recurring elements and aims to arrive at the best possible estimate of repeatable average earnings over a span of future years. Accounting, as we have seen, can supply much of the essential information for the computation of earning power. However, the process is one involving knowledge, judgment, experience as well as a specialized investing or lending point of view. We know investors and lenders look ultimately to future cash flows as sources of rewards and safety. Accrual accounting, which underlies income determination, aims to relate sacrifices and benefits to the periods in which they occur. In spite of its known shortcomings, this framework represents the most reliable and relevant indicator of longer-term future probabilities of average cash inflows and outflows presently known.

20. Interim financial statements, most frequently issued on a quarterly basis, are designed to

fill the reporting gap between the year-end statements. They are used by decision makers as means of updating current results as well as in the prediction of future results. If a year is a relatively short period of time in which to account for results of operations for many analytical purposes, then trying to confine the measurement of results to a three-month period involves all the more problems and imperfections. Generally, the estimating and adjustment procedures at interim financial statement dates are performed much more crudely than for year-end financial statements. The net result is that the interim reports are less accurate than year-end reports that are audited. Another serious limitation to which the interim reports are subject is the seasonality of activities to which most businesses are subject. Sales may be unevenly distributed over the year and this tends to distort comparisons among the quarterly results of a single year. It also presents problems in the allocation of many costs. Similar allocation problems are encountered with the extraordinary and other nonrecurring elements. Despite these limitations, interim reports can provide useful information if the analysts are fully aware of the possible pitfalls and use them with extreme care. The analyst can overcome some of the seasonality problem by considering in the analysis not merely the results of a single quarter but rather the year-to-date cumulative results.

21. The reporting of interim earnings is subject to limitations and distortions. The intelligent

use of reported interim results requires that we have a full understanding of the possible problem areas and limitations. The following is a review of some of the basic reasons for these problems and limitations as well as their effect on the determination of reported interim results: Year-End Adjustments. The determination of the results of operations for a year requires many estimates, as well as procedures such as accruals and the determination of inventory quantities and carrying values. These procedures can be complex, time consuming, and costly. Examples of procedures requiring a great deal of data collection and estimation includes estimation of the percentage of completion of contracts, determination of cost of work in process, the allocation of under- or over-absorbed overhead for the period and the determination of inventory under the LIFO method. The complex, time-consuming, and expensive nature of these procedures can mean that they are performed much more crudely during interim periods and are often based on records that are less complete than their year-end counterparts. The result inevitably is a less accurate process of income determination which, in turn, may require year-end adjustments which can modify substantially the interim results already reported.


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Seasonality. Many companies experience at least some degree of seasonality in their activities. Sales may be unevenly distributed over the year and so it may be with production and other activities. This tends to distort comparisons among the quarterly results of a single year. It also presents problems in the allocation of many budgeted costs, such as advertising, research and development, and repairs and maintenance.

22. The major disclosure requirements by the SEC with regard to interim reports are: • Comparative quarterly and year-to-date abbreviated income statement data—this

information may be labeled "unaudited" and must also be included in annual reports to shareholders.

• Year-to-date statements of cash flows; • Comparative balance sheets; • Increased pro forma information on business combinations accounted for as

purchases; • Conformity with the principles of accounting measurement as set forth in the

professional pronouncements on interim financial reports; • Increased disclosure of accounting changes with a letter from the registrant's

independent public accounting firm stating whether or not it judges the changes to be preferable;

• Management's narrative analysis of the results of operations, explaining the reasons for material changes in the amount of revenue and expense items from one quarter to the next.

• Indications as to whether a Form 8-K was filed during the quarter reporting either unusual charges or credits to income or a change of auditors;

• Signature of the registrant's chief financial officer or chief accounting officer. The objectives behind these disclosures are: • They will assist investors in understanding the pattern of corporate activities

throughout a fiscal period. • Presentation of such quarterly data will supply information about the trend of

business operations over segments of time that are sufficiently short to reflect business turning points.

23. While there have been some notable recent improvements in the reporting of interim

results, the analyst must remain aware that accuracy of estimation and the objectivity of determinations are and remain problem areas which are inherent in the measurement of results of very short periods. Also, the limited association of auditors with interim data, while lending as yet some unspecified degree of assurance, cannot be equated to the degree of assurance which is associated with fully audited financial statements. SEC insistence that the professional pronouncements on interim statements be adhered to should offer analysts some additional comfort. However, not all principles promulgated on the subject of interim financial statements result in presentations useful to the analyst. For example, the inclusion of extraordinary items in the results of the quarter in which they occur will require careful adjustment to render them meaningful for purposes of analysis. While the normalization of expenses is a reasonable intra-period accounting procedure, the analyst must be aware of the fact that there are no rigorous standards or rules governing its implementation and that it is, consequently, subject to possible abuse. The shifting of costs between periods is generally easier than the shifting of sales; and, therefore, a close analysis of sales may yield a more realistic clue to a


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company's true state of affairs for an interim period. Some problems of seasonality in interim results of operations can be overcome by considering in the analysis, not merely the results of a single quarter, but also the year-to-date cumulative results that incorporate the results of the latest available quarter. This is the most effective way of monitoring the results of a company and bringing to bear on its analysis the latest data on operations that are available.


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EXERCISES Exercise 11-1 (45 minutes) a. Schedule of Maintenance and Repairs (scaled) Total Average

Year 9 Year 10 2 years 2 years Year 11

Revenues [1] ............................. $4,879.4 $5,030.6 $9,910.0 $4,955.0 $5,491.2 PP&E (net) [66] ......................... 959.6 1,154.1 2,113.7 1,056.9 1,232.7 Maintenance & Repairs [155] .. 93.8 96.6 190.4 95.2 96.1 % of Maintenance & Repairs to Revenue .................. 1.92% 1.92% 1.92% 1.92% 1.75% % of Maintenance & Repairs to PP&E, net ............... 9.77% 8.37% 9.01% 9.01% 7.80% b. The percentage of maintenance and repairs to revenues in Year 11 (1.75%) is

lower than the same percentage scaled by the average of Years 9 and 10 (1.92%). Assuming that the 2-year average is representative of a longer period pattern, it would appear that management may have been saving on discretionary costs in Year 11 to prop up income. The percentage of maintenance and repairs to net PP&E exhibits the same pattern and also signals an effort by management to lower costs.

For example, assume total savings equals the difference between the actual expenditure on maintenance and repairs in Year 11 and the amount of spending required to equate the rate of spending implicit in the average percentage to revenues for the preceding years: Implicit spending = $5,491.2 x 1.92% = $105.4 Actual spending in Year 11 ............ = 96.1 "Savings" ......................................... = $ 9.3 (8.8% of implicit spending) PPE (net) x Ave % = $1,232.7 x 9.01% = $111.1 Actual ............................................... = 96.1 "Savings" ......................................... = $ 15.0 (13.5% of implicit spending)


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Exercise 11-2 (60 minutes) a. The president is correct in designating most of the items described as normal

operating expenses that good managers should expect and anticipate. Many diverse views still prevail on how extraordinary items should be presented. They differ due to different conceptions regarding the purposes of the income statement and those of financial statement analysis.

Basically, preparers of the income statement should recognize that they have a

varied audience and that it is best to give the reader all the information that s/he may need to arrive at an income figure adjusted for his/her own purposes and abstain from built-in interpretations. The designation of an item of gain or loss as extraordinary carries with it an interpretative message. Consequently, only in those relatively rare cases when an item is both non-operating and nonrecurring may it be designated as extraordinary (based on firsthand knowledge of attending circumstances) and be useful to the user of financial statements.

b. To qualify for the "extraordinary" presentation category in the income statement

the item must be both unusual and non-recurring in nature. However, the classification of an item as extraordinary for accounting purposes is often dictated by considerations that are not relevant to the objectives of the analyst. Therefore, each analyst should establish his/her own criteria for the classification to suit his/her particular analytical purpose and, if so, how to adjust for it. Some of the frequently used guidelines are:

(1) Nonrecurring operating gains and losses, (2) Recurring non-operating gains and losses, (3) Non-recurring, non-operating gains and losses.


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Exercise 11-2—concluded c. 1. No. This is an expected business event, although it may not be predictable. It

is not different from events such as an increase of import duties and taxes. 2. No. It may be "nonrecurring," however, it is expected in business. 3. No. It indicates superior performance by competitors--a frequent occurrence. 4. No. Tax is legitimate, unavoidable business cost and any change in taxation

should affect other companies in the industry as well. 5. No. Strikes may not be an annual event; however, they are a recurring

operational possibility. 6. No. It is a "nonrecurring" cost of an operating nature. 7. No. It can occur in any business and it reflects management's planning and

judgment. 8. No. This danger is always inherent in research and development. 9. No. This risk is part of software development. 10. No. It reveals a failure of credit policy. 11. No. Capital gains and losses resulting from rental cars should be regarded as

operating items of a car rental company. 12. No. The analyst, however, should carefully analyze the circumstances in order

to determine if it qualifies under "nonrecurring" and "nonoperating" event. 13. No. Amounts involved are generally minor and the operation of the houses

should be viewed as a part of the whole operation. 14. Yes. However, it may inform the analyst that management is unprepared for

such an event. 15. Yes. It may qualify as a "nonrecurring, nonoperating" event. 16. Yes. It appears to qualify as a “nonrecurring, nonoperating” event.


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Exercise 11-3 (30 minutes) a. Many views prevail on how extraordinary items should be presented. They differ

with differing conceptions regarding the purposes of the income statement and those of financial statement analysis. Basically, preparers of the income statement should recognize that they have a varied audience and that it is best to give the reader all the information that he/she may need to arrive at an income figure adjusted for his/her own purposes. The designation of an item of gain or loss as extraordinary carries with it an interpretative message. Consequently, only in those relatively rare cases when an item is both nonoperating and nonrecurring may its designation as extraordinary (based on the preparer's firsthand knowledge of attending circumstances) be useful to the user of financial statements.

b. The analyst must assess the importance of items presented as extraordinary—

namely, the probability of their recurrence and the likelihood that they represent a symptom of operating conditions that are likely to be increasingly prevalent. On the basis of such an evaluation, s/he can decide how to consider them in the computation of average earnings, average coverage ratios, return on invested capital ratios, and other measures. The analyst also can determine their impact in the evaluation of management and in the forecasting of earnings. Generalizations, or preconceived classifications, are less useful in this area.


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Exercise 11-4 (40 minutes) a. Sales and other revenues should be recognized for interim financial statement

purposes in the same manner as revenues are recognized for annual reporting purposes. This means normally at the point of sale or, in the case of services, at completion of the earnings process. In the case of industries whose sales vary greatly due to the seasonal nature of business, revenues should still be recognized as earned, but a disclosure should be made of the seasonal nature of the business in the notes. In the case of long-term contracts recognizing earnings on the percentage-of-completion basis, the current state of completion of the contract should be estimated and revenue recognized at interim dates in the same manner as at the normal year-end.

b. For interim reporting purposes, product costs (costs directly attributable to the

production of goods or services) should be matched with the product and associated revenues in the same manner as for annual reporting purposes. Period costs (costs not directly associated with the production of particular goods or service) should be charged to earnings as incurred or allocated among interim periods based on an estimate of time expired, benefit received, or other activity associated with the particular interim period(s). Also, if a gain or loss occurs during an interim period and is a type that would not be deferred at year-end, the gain or loss should be recognized in full in the interim period in which it occurs. Finally, in allocating period costs among interim periods, the basis for allocation must be supportable and may not be based on merely an arbitrary assignment of costs between interim periods.


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c. GAAP allow for some variances from the normal method of determining cost of

goods sold and valuation of inventories at interim dates, but these methods are allowable only at interim dates and must be fully disclosed in a footnote to the financial statements. Some companies use the gross profit method of estimating cost of goods sold and ending inventory at interim dates instead of taking a complete physical inventory. This is an allowable procedure at interim dates, but the company must disclose the method used and any significant variances that subsequently result from reconciliation of the results obtained using the gross profit method and the results obtained after taking the annual physical inventory. At interim dates, companies using the LIFO cost-flow assumption may temporarily have a reduction in inventory level that results in a liquidation of base period inventory layers. If this liquidation is considered temporary and is expected to be replaced prior to year-end, the company should charge cost of goods sold at current prices. The difference between the carrying value of the inventory and the current replacement cost of the inventory is a current liability for replacement of LIFO base inventory temporarily depleted. When the temporary liquidation is replaced, inventory is debited for the original LIFO value and the liability is removed. Also, inventory losses from a decline in market value at in-

Exercise 11-4—concluded

terim dates should not be deferred but should be recognized in the period in which they occur. However, if in a subsequent interim period the market price of the written-down inventory increases, a gain should be recognized for the recovery up to the amount of the loss previously recognized. If a temporary decline in market value below cost can reasonably be expected to be recovered prior to year-end, no loss should be recognized. Finally, if a company uses a standard costing system to compute cost of goods sold and to value inventories, variances from standard should be treated at interim dates in the same manner as at year-end. However, if variances occur at an interim date that are expected to be absorbed prior to year end, the variances should be deferred instead of being immediately recognized.


11-19

d. The provision for income taxes shown in interim financial statements must be based upon the effective tax rate expected for the entire annual period for ordinary earnings. The effective tax rate is, in accordance with previous APB opinions, based on earnings for financial statement purposes as opposed to taxable income that may consider timing differences. This effective tax rate is the combined federal and state(s) income tax rate applied to expected annual earnings, taking into consideration all anticipated investment tax credits, foreign tax rates, percentage depletion capital gains rates, and other available tax planning alternatives. Ordinary earnings do not include unusual or extraordinary items, discontinued operations, or cumulative effects of changes in accounting principles, all of which will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year. The amount shown as the provision for income taxes at interim dates should be computed on a year-to-date basis.

For example, the provision for income taxes for the second quarter of a company's fiscal year is the result of applying the expected rate to year-to-date earnings and subtracting the provision recorded for the first quarter. There are several variables in this computation (expected earnings may change, tax rates may change), and the year-to-date method of computation provides the only continuous method of approximating the provision for income taxes at interim dates. However, if the effective rate or expected annual earnings change between interim periods, the change is not reflected retroactively but the effect of the change is absorbed in the current interim period.


11-20

Exercise 11-5 (25 minutes) The suggested solution is a general one. It must be emphasized that the impact of these factors will be different depending on whether the company is in a growth, cyclical, and/or defensive phase. Still, these factors will have some effect on most companies. a. Factors deriving from the company that affect:

(1) Earnings per Share • Accounting policy, particularly inventory and depreciation. • Sales volume, cost of goods sold, and operating expenses. • Quality of management and R&D. • Success of new product introduction. • Start-up expense, special items, nonrecurring gains or losses. • Expansion programs--internal or through acquisition. • Leverage. • Overall financial policies.

(2) Dividends per share

• Capital expenditure programs. • Volatility or stability of net income. • Overall financial condition. • Alternative uses of cash. • Replacement of fixed assets. • Stage of life cycle of company--youth, middle, mature. • Sinking fund requirements.

(3) Market price per share

• Quality of management. • Growth rate of net income and earnings per share. • Quality of earnings, profit margins, research, competitive environment. • Price-earnings ratio accorded. • Financial management. • Trading on equity, leverage. • New product development, general outlook. • Information disseminated by management so as to allow an intelligent

analysis of projects.


11-21

• Exercise 11-5—concluded b. Factors deriving from the economy that affect:

(1) Earnings per share • If the economy turns up or down, and a company makes products whose

demand turns with the general economy, earnings will be variable compared to a company whose products are subject to stable or constantly growing demand.

• Government intervention can influence EPS by preventing price rises or forcing uneconomic labor settlements.

• Labor disturbances halting operations, lowering revenues and hence EPS. Companies with poor labor relation policies are subject to such variability in earnings.

• Changes in consumer fads or styles of living can cause variance until the affected company catches up again.

• Population shifts out of areas served. • Changes in tax laws.

(2) Dividends per share

• Tax laws. • Growth rate of economy encouraging reinvestment. • Of course, anything affecting EPS affects dividends also --not necessarily

immediately, but at least in terms of dividend policy.

(3) Market price per share • Investor confidence in the ability of the government to cope with problems. • Cyclical change in economy affecting investor confidence which is

reflected in the stock market in general. Research indicates that over 50 percent of price movements for a typical stock are due to price movements of the general market.


11-22

PROBLEMS Problem 11-1 (70 minutes) a.

Quaker Oats Recast Income Statements ($ millions)

For Years Ended Year 11, Year 10 and Year 9 Year 11 Year 10 Year 9

Net sales ...................................................................... 5,491.2 5,030.6 4,879.4 Interest income ........................................................... 9.0 11.0 12.4 Total revenue .............................................................. 5,500.2 5,041.6 4,891.8 Costs and expenses Cost of sales [a] ....................................................... 2,647.0 2,528.1 2,514.0 Selling, general and admin expenses [b] .............. 669.5 605.5 597.0 Repair and maintenance expenses [a] .................. 96.1 96.6 93.8 Depreciation expenses [a] ...................................... 125.2 103.5 94.5 Advertising and merchandising expenses [b] ...... 1,407.4 1,195.3 1,142.7 Research and development [b] .............................. 44.3 43.3 39.3 Interest expenses [c] ............................................... 95.2 112.8 68.8 Foreign exchange (gains) losses ........................... (5.1) 25.7 14.8 Amortization of intangibles .................................... 22.4 22.2 18.2 Losses (gains) from plant closing and ops sold .. 8.8 (23.1) 119.4 Miscellaneous expenses (income) ......................... 6.5 (8.4) (2.8) Total costs and expenses .......................................... 5,117.3 4,701.5 4,699.7 Income before taxes ................................................... 382.9 340.1 192.1 Taxes (at 34%) ............................................................. 130.2 115.6 65.3 Income from continuing operations ......................... 252.7 224.5 126.8

See explanatory notes [a] through [c] on next page.


11-23

Problem 11-1—concluded

Notes: 11 10 9

[a] Cost of goods sold .......................................................... 2,839.7 2,685.9 2,655.3

Less: Repair and maintenance expenses ..................... (96.1) (96.6) (93.8) Less: Depreciation expense ........................................... (125.2) (103.5) (94.5) Add: LIFO liquidation gain before tax* .......................... 28.6 42.3 47.0

2,647.0 2,528.1 2,514.0 * LIFO liquidation gain (pre-tax): Year 11 = 18.9/(1 - .34) = 28.6; Year 10 = 27.9/(1 - .34) = 42.3; Year 9 = 31.0/(1 - .34) = 47.0

[b] Selling, General and Administrative expenses ............. 2,121.2 1,844.1 1,779.0

Less: Advertising and merchandising expenses (1,407.4) (1,195.3) (1,142.7) Less: Research and development ................................. (44.3) (43.3) (39.3) 669.5 605.5 597.0

[c] Interest expense .............................................................. 101.9 120.2 75.9

Less: Interest allocated to disc ops ............................... (6.7) (7.4) (7.1) 95.2 112.8 68.8

b. Analysis and Interpretation.

Unlike reported net income, income from continuing operations has grown significantly over the three year period Year 9 – Year 11. Income (loss) from discontinuing operations had a marked effect on net results. Also, the LIFO liquidation gains decline over this three-year period. Moreover, advertising and merchandising expenses increased markedly, while repair and maintenance, as well as R & D expenses, remain stable.


11-24

Problem 11-2 (75 minutes) a. Step 1: Compute Amount to be Allocated:

Purchase price of Finex (given) ................................................. $700,000 Book value of total equity 1 ......................................................... 570,000 Payment in excess of book value ............................................... 130,000 Add: Decrease in accounts receivable (5%) .............................. 7,500 Amount to be allocated to Land, Buildings and Equipment ..... $137,500 1 Preferred stock + Common stock + Paid-In capital + Retained earnings. Step 2: Allocate amount to individual assets: Land 1 ................................................................................................ $ 10,377 Buildings 2 ........................................................................................ 93,396 Equipment 3 ...................................................................................... 33,727

Total ................................................................................................... $137,500 1 [40,000 / (40,000 + 360,000 + 130,000)] x 137,500.

2 [360,000 / (40,000 + 360,000 + 130,000)] x 137,500. 3 [130,000 / (40,000 + 360,000 + 130,000)] x 137,500. Step 3: Compute reported values to assign to individual assets: Land ($40,000 + $10,377) ......................................................... $ 50,377 Building ($360,000 + $93,396) .................................................. $453,396 Equipment ($130,000 + $33,727) ............................................. $163,727 b.

Finex, Inc. Pro Forma Balance Sheet As of January 1, Year 2

ASSETS Cash ............................................................ $ 55,000 (unchanged) U.S. government bonds ............................ 25,000 (unchanged) Accounts receivable (net) ......................... 142,500 (less 5%) Merchandise inventory ............................. 230,000 (unchanged) Land ............................................................ 50,377 (restated) Building ...................................................... 453,396 (restated) Equipment ................................................. 163,727 (restated)

Total assets ................................................ $1,120,000 LIABILITIES AND EQUITY Accounts payable ...................................... $ 170,000 (unchanged) Notes payable ............................................ 50,000 (unchanged) Bonds payable ........................................... 200,000 (unchanged) Preferred stock .......................................... 100,000 (unchanged) Common stock ........................................... 400,000 (unchanged) Paid-in capital and retained earnings * ... 200,000 (increase of $130,000) Total liabilities and equity ......................... $1,120,000

* Component amounts will vary with method of acquisition.


11-25

Problem 11-2—concluded c.

Finex, Inc. Pro Forma Income Statement

For Year Ended December 31, Year 2

Net sales ........................................................ $860,000 100.0%

Cost of goods sold ....................................... $546,000

Add: Increased depreciation in COGS1 ....... 664 546,664 63.6

Gross profit .................................................... 313,336 36.4

Selling & administrative expenses .............. 240,000

Add: Increase in depreciation expense:1

Year 2 ($18,892 - $6,297=$12,595)

Year 1 ($16,900 - $5,633=$11,267) ............. 1,328 241,328 28.0

Net operating income ................................... $ 72,008 8.4 1 Depreciation rates before purchase: Building: 7,900 / (360,000 + 35,000) = 2% Equipment: 9,000 / (130,000 + 20,000) = 6%

Estimated depreciation expense in Year 2: Building: $453,396 x 2% = $ 9,068 Equipment: $163,727 x 6% = 9,824 Total = $18,892

Estimated depreciation in COGS in Year 2 ($18,892 x 1/3) $6,297 Estimated depreciation in COGS in Year 1 [($7,900+$9,000) x 1/3] 5,633 Increase in depreciation expense $ 664 d. Yes, the pro forma net operating income is 8.4% of net sales.


11-26

Problem 11-3 (60 minutes) Analysis of Credit Constraint from Bank America Step 1: Construct a Pro Forma Gross Profit Schedule

Sales ........................................................... $500,000 Less 10% sales returns ................................ $ 50,000 2% sales discount ................................ 10,000 60,000 Net Sales ..................................................... 440,000 Cost of goods sold Beginning inventory ($138,000/1.38) ... 100,000 Purchases ............................................. $400,000 Less 2% purchases returned ........................ (8,000) 1% purchases discount ....................... (4,000) 388,000 488,000 Less: Ending inventory ....................... 138,000 350,000 Gross Profit ................................................ $ 90,000

Step 2: Compute Gross Margin to Sales Gross margin to sales = $90,000 / $440,000 = 20.45% Step 3: Assess whether Aspero meets Credit Constraint Bank America would not extend a loan to Aspero (20.45% < 25% min.) Analysis of Credit Constraint from Bank Boston Step 1: Compute Current Liabilities (Accounts Payable is its only current liability) Current liabilities = Purchases ÷ Accounts payable turnover Accounts payable turnover = 360 ÷ 90 = 4 Accounts payable = 388,000 ÷ 4 = $97,000 Step 2: Compute Current Assets Current Assets Cash ....................................................................... $ 5,500 Accounts receivable [a] ........................................ 55,000 Inventory ................................................................ 138,000 Total Current Assets ............................................. $198,500 [a] A.R. = Sales ÷ A.R. turnover = 440,000 ÷ (360/45) = 55,000.

Step 3: Compute Current Ratio Current ratio = $198,500 ÷ $97,000 = 2.05 Step 4: Assess whether Aspero meets Credit Constraint Bank Boston would extend a loan to Aspero (2.05 > 2.0 min.)


11-27

Problem 11-4 (60 minutes) a. Residual Income Computation Year 1: $12,500 - (.15)($50,000) = $5,000 [5,000]*

Year 2: $11,700 - (.15)($56,500) = $3,226 [3,225]* Year 3: $11,420 - (.15)($63,845) = $1,845 [1,843]* Year 4: $11,860 - (.15)($72,145) = $1,039 [1,038]* Year 5: $10,820 - (.15)($72,145) = $ 0 [ -2]* *Note: Consistent with the example in the text, the figures are based on rounding ROCE to two digits. The figures without rounding are reported in parentheses.

b. Estimate of Equity Value 1/1/Year 2: $56,500 + $3,226/1.152 + $1,845/1.153 + $1,039/1.154 ....... $60,747

1/1/Year 3: $63,845 + $1,845/1.153 + $1,039/1.154 ................................ $65,652 1/1/Year 4: $72,145 + $1,039/1.154 ........................................................ $72,739 1/1/Year 5: ........................................................................................... $72,145

c. Conservative accounting principles tend to understate net income and book

value. As long as the analyst's estimates of future profitability incorporate the eventual reversal of this conservatism under the clean surplus relation, value estimates will not be affected by conservative accounting.

d. Estimate of PB 1/1/Year 2: 1 + (.2071-.15)/1.15 + [(.1789-.15)/1.152] x [$63,845/$56,500] + [(.1644-.15)/1.153] x [$72,145/$56,500] = 1.09 1/1/Year 3: 1 + (.1789-.15)/1.15 + [(.1644-.15)/1.152] x [$72,145/$56,500] = 1.04 1/1/Year 4: 1 + (.1644-.15)/1.15] = 1.01 1/1/Year 5: 1.00 e. Estimate of PE (Note: "Normal" PE = 1.15/.15 = 7.67):

1/1/Year 3: 7.67 + [7.67/$11,700] x [($1,845-$3,226)/1.15 + ($1,039-$1,845)/1.152 + ($0-$1,039)/1.153] - $4,355/$11,700 = 5.66 1/1/Year 4: 7.67 + [7.67/$11,420] x [($1,039-$1,845)/1.15 + ($0-$1,039)/1.152] - $3,120/$11,420 = 6.40 1/1/Year 5: 7.67 + [7.67/$11,860] x [($0-$1,039)/1.15] - $11,860/$11,860 = 6.08


11-28

CASES Case 11-1 (90 minutes) a.

Ferro Corporation Recast Income Statements ($000s) For Years Ended Year 5 and Year 6

Year 6 Year 5 Net sales ................................................................................ $376,485 $328,005 Cost of sales [a] ..................................................................... 251,846 210,333 Selling & administrative expenses [b] ................................. 48,216 42,140 Repairs & maintenance [a] ................................................... 15,000 20,000 Advertising expense [b] ........................................................ 6,000 7,000 Employee training program [b] ............................................ 4,000 5,000 Research & development ...................................................... 9,972 8,205 335,034 292,678 Operating Income .................................................................. 41,451 35,327 Other income: [c] Royalties ........................................................................... 710 854 Interest earned ................................................................. 1,346 1,086 Miscellaneous .................................................................. 1,490 1,761 Total other income ........................................................... 3,546 3,701 Other charges: [d] Interest expense .............................................................. 4,055 4,474 Miscellaneous .................................................................. 1,480 1,448 Total other charges .......................................................... 5,535 5,922 Income before taxes .............................................................. 39,462 33,106 Income taxes (at 48%, before items below) [e] ................... 18,942 15,891 Income from continuing operations .................................... 20,520 17,215 Add (deduct) permanent tax differentials: Lower tax rate on earnings of consolidated subsidiaries (Year 6: 36,819 x 5.3%) [e] ........................ 1,951 1,312 Lower tax rate on equity in income of affiliated companies (Year 6: 36,819 x 1.4%) [e] .......................... 516 198 Unrealized foreign exchange loss, not tax deductible (Year 6: 36,819 x 5.3%) [e] .............................................. (1,951) (891) Added US taxes on dividends from subsidiaries, etc. (Year 6: 36,819 x .8%) [e] ................................................ (295) (248) Investment tax credit (Year 6: 36,819 x 1.5%) [e] ............ 552 223 Miscellaneous tax benefits (Year 6: 36,819 x .4%) —rounded [e] ................................................................... 135 158 Equity in earnings of affiliates (net of tax) (Year 6: 1,394 x .52) [c] ................................................... 725 262 Unrealized loss on foreign currency translation (net of tax) (Year 6: 4,037 x .52) [d] ................................ (2,099) (963) Loss from disposal of chemicals division (net of tax) (Year 5: 7,000 x .52) [a] ................................................... (3,640) Net income as reported ......................................................... $ 20,054 $ 13,626


11-29

Case 11-1—concluded Notes: Notations [a], [b], etc., indicate related items in the statement. For example, repairs and maintenance is separated from cost of goods sold.

b. Factors causing the effective tax rate to be greater than the statutory rate include

the (1) unrealized foreign exchange translation loss, and (2) additional taxes on dividends from subsidiaries and affiliates. Of these factors, changes in foreign exchange rates may be considered random. Dividend policy is under the control of management. The factors causing the effective tax rate to be less than the statutory rate include the: (1) earnings of consolidated subsidiaries taxed at rates less than the US rate, (2) equity in after-tax earnings of affiliates, (3) ITC, and (4) miscellaneous. Of these factors, the ITC is unstable as it depends on government policy.

c. While Ferro's sales grew by only 14.8%, net income from continuing operations

increased by 19.2%. The increase in the net income to sales ratio may have resulted from "savings" in repairs and maintenance (R&M), advertising, and employee training program expenses. The following analysis explains these "savings":

Actual Difference

Year 5 Year 6 Amount Benchmark* (savings)

% R&M to Sales ............................ 6.1 4.0 $15,000 $22,970 $ 7,970 % Advertising to Sales ................ 2.1 1.6 6,000 7,910 1,910 % Employee Training to Sales .... 1.5 1.1 4,000 5,650 1,650

$25,000 $36,530 $11,530

The Year 6 % NI to Sales (on Year 5 basis) would be:

Net income from continuing operations ........... .......................... $20,520 Less "savings" on discretionary items ($11,530 x .52) .............. 5,995 Net income on adjusted basis ** ................. .......................... $14,525 % of net income to sales ($14,525/$376,485)*** .......................... 3.8%

Note: The disposal of the chemical division may have affected cost patterns. * Amount of spending required in Year 6 to equal the spending implicit in the Year 5 ratios. ** Adjusted to reflect discretionary costs at the same level as prevailed in Year 5. *** % of NI to Sales as reported is 5.3%.


11-30

Case 11-2 (80 minutes) Reaction to Proposals 1 through 3 (1) The tonnage-of-production method provides an especially good matching of

depreciation expense against revenues for Canada Steel's highly cyclical business. A unit-of-production method effectively makes depreciation a variable rather than a fixed cost and, therefore, tends to stabilize earnings. Casting metals is not a high technology business, and actual wear and tear on the equipment is more relevant to replacement need than technological obsolescence. A switch to straight-line would not eliminate the deferred tax liability as this difference is caused by accelerated methods and shorter lives rather than by the difference between the tonnage-of-production and straight-line methods. Moreover, Canada Steel should not attempt to extinguish this liability since it is an interest-free loan from the government, which may never have to be repaid as long as new assets are acquired. A switch to straight-line would leverage profits on any production increase (or decrease) because depreciation expense would be a direct function of time rather than units produced. However, the quality of earnings may be reduced by a switch to straight-line since this method would accentuate the highly cyclical nature of the business and result in increased income volatility.

(2) The reasons for adopting the LIFO method—reducing taxes and increasing cash

flow—are still valid. Inflation usually declines during recessions, but this does not mean its recurrence is improbable. Maximizing cash flow remains important to the corporation and shareholders. A return to FIFO would relinquish the tax savings of prior years, although it is true that the balance sheet and income statement would be strengthened by the change. The quality of earnings is likely to be affected adversely by the lack of consistency in inventory method (two changes in a period of several years) and a perception that the motive in making the change was to increase book value per share, avoid two consecutive unprofitable years, and escape violation of a loan covenant. The $4 million upward adjustment in working capital is a result of increasing the inventory account by this amount, which has the effect of increasing the current ratio as shown below:

LIFO FIFO

Current assets ................................................. $10.5 $14.5 Current liabilities ............................................. $ 4.5 $ 4.5 Current ratio ..................................................... 2.3 3.2 The $0.5 million increment to net income will offset an operating loss of $0.4 million, which would not be unexpected on a sales decline of 31%. In addition, the $2.0 million addition to shareholders' equity from prior years' profits is likely to be far less significant than current profit trends (Canada Steel has had to disclose regularly in the notes to its financial statements the difference in inventory values resulting from the use of LIFO versus FIFO).


11-31

Case 11-2—concluded (3) The inventory change will enable Canada Steel to meet the minimum current ratio

requirements. However, the stock repurchase program should not be recommended for the following reasons:

• The proposed repurchase price of $100 per share is well above book value and

recent market prices, suggesting dilution for remaining shareholders. • The potential dividend savings are outweighed by interest costs of $101,000 ($2.0

million x 11% x 0.46 marginal tax rate) to finance the purchase--in other words, leverage is negative.

• The debt-to-equity ratio has increased significantly from 10% ($2.0 million long-term debt/$17.7 million equity + $2.0 million long-term debt) to 35% ($6.1 million long-term debt/$11.4 million equity + $6.1 million long-term debt). An additional $2.0 million of stock repurchased would raise this ratio to 41% ($8.1 million long-term debt/$11.5 million equity + $8.1 million long-term debt). The increased financial risk is particularly inappropriate for an industry with significant sensitivity to the business cycle. Shrinking shareholders' equity under present circumstances is prudent only by sale of fixed assets, not the incurring of additional debt.

In sum, each of the foregoing proposals 1-3 would have a negative impact on the quality of Canada Steel's earnings.


11-32

Case 11-3 (75 minutes) a. Estimation of Equity Valuation

1 2 3 4 5 6 7 Net income ........................ 1,034 1,130 1,218 1,256 1,278 1,404 1,546 Book value, beginning ..... 5,308 5,292 5,834 6,338 6,728 7,266 7,856 Residual income [a] .......... 344 442 460 432 403 459 525 PV factor (at 13%) ............. .885 .783 .693 .613 .543 .480 .425 PV residual income ........... 304 346 319 265 219 221 223

[a] Residual income = NI - (13% x Beginning book value). Value at 1/1/Year 1 = $5,308 +$304 +$346 + $319 + $265 + $219 + $221 + $223 = $7,205 b. Computation and Interpretation of PB: PB ratio = $7,205 / $5,308 = 1.36

Assuming accurate estimates, a market-based PB of 1.95 implies that Colin is overvalued. One might consider selling-short Colin stock.

c. Computation and Interpretation of PE: PE ratio = $7,205 / $1,034 = 6.97

Assuming accurate estimates, a market-based PE of 10 implies that Colin is overvalued. One might consider selling-short Colin stock.

d. Estimation of Equity Valuation

1 2 3 4 5 6 7 8+

Net income ................ 1,034 1,130 1,218 1,256 1,278 1,404 1,546 1,546 Book value, beg ........ 5,308 5,292 5,834 6,338 6,728 7,266 7,856 8,506 Residual income [a] ..... 344 442 460 432 403 459 525 440 PV factor (at 13%) ..... . .885 .783 .693 .613 .543 .480 .425 3.270 [b] PV residual income ...... 304 346 319 265 219 221 223 1439

[a] Residual income = NI - (13% x Beginning book value). [b] To discount a perpetuity to beginning of Year 1: (1) Divide $1,439 by 0.13 to arrive at value as

of 1/1/Year 8, and multiply by 7-year present value factor of 0.425 [0.425/0.13 = 3.270]. Value at 1/1/Year 1 = $5,308 +$304 +$346 +$319 +$265 +$219 +$221 +$223 +$1,439 = $8,644


11-33

Case 11-4 (60 minutes) a. The revenue model was adopted since many of the firms initially did not have net

income or cash inflows. While this may be an excuse for limitations in valuation models, the reality is that a revenue model directly values these companies based on their primary source of cash inflows. As the businesses mature, they will become profitable as they reach economies of scale with respect to their cost structures. The revenue model considers the companies’ prospects for such growth. The “non-financial’ metrics provide information on capacity and efficiency. For example, revenue per head is a measure of how well each firm is utilizing its personnel. Billable headcount is a measure of size and speaks to economies of scale issues. Billing rates reflect the value of the services provided. Firms that offer front- and back-end services have a higher average billing rate than firms that develop Web storefronts. Annual turnover speaks to each firm’s cost structure. Higher turnover means higher costs and lower utilization since new hires are sent to training programs and are billed to customers. Average utilization is the percentage of annual billable hours (2,080) per employee that are billed to clients. This measure excludes administrative and financial personnel.

b. The revenue multiples reflect prospects for growth and the value of services

provided. Those firms that provide both front- and back-end services trade at a higher revenue multiple since they have better prospects for sustained revenue streams.

c. Headcount measures can be problematic in periods of high growth since new

hires are included in the headcount measures upon hire. That means that revenue per head and average utilization are understated since the new hires are sent to training and do not initially generate revenue or work billable hours. Higher turnover measures have a similar effect.

d. The revenue multiples are lower since a firm can only double in size so many

times. In other words, growth rates slow over time so the prospects for growth also diminish. Lower multiples reflect this phenomenon.

e. Razorfish was trading at nearly three times the revenue multiple that I-Cube was

trading at when the deal was made. Analysts viewed the transaction as positive. There was a consensus among the analysts that follow Razorfish that value would come from operating improvement and not just financial engineering. The acquisition of I-Cube allowed Razorfish to add expertise it did not possess and allowed them to come closer to being able to offer complete front- and back-end services. In this case, the 18% premium appears to be a good buy for Razorfish.

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